Self-Help Guide IRS 501(c)(3) Exempt Status Geared Towards "Charitable" type Organizations

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INTRODUCTION:

Obtaining tax exempt status can be labor intensive and tricky. This document will not tell you how to answer every question on the application. Use the instructions provided by the IRS. Instead, this article provides background information, suggestions, and tips to help you understand some of the issues. Our goals is to help you avoid common booby traps that can torpedo your application.

THE NECCESSARY APPLICATION FORMS

• Form 1023: Application for Exempt Status
• Form 1023 - Instructions
• Form 8718: User Fee Determination Request
• Form SS4: Application for Employer ID Number
• IRS Publication 557, Exempt Status for Your Organization

You can download these forms & publications directly from the website maintained by the IRS. CLICK HERE to go to the IRS download page. Or you can use their toll free number to order them over the phone 800 829-3676 (allow about two weeks for delivery). These forms are also available locally from any IRS walk in office.

WHAT DOES TAX EXEMPT STATUS MEAN?:

 501(c)(3) is a just one of twenty-two different types of organizational tax exemptions granted by the IRS under section 501 of the Code.  501(c)(3) exemptions are for “charitable,  educational, and religious” organzanations. For reasons discussed below, 501(c)(3) is the most desirable of all exemptions because of the “goodies” that come with it.  The other (less desirable) types of exemptions are for organizations such as civic leagues, social welfare labor unions, business leagues, social clubs, farmer's coops, etc.


WHAT ARE THE ADVANTAGES OF BEING A SECTION 501(C)(3) ORGANIZATION?:

 There are two advantages over other types of tax exempt status, both of which relate to fund raising ability:

• Contributions are tax deductible for the donor
  
• Only 501(c)(3) organizations qualify for foundation grants.
  

WHAT IS A 501(C)(3) ORGANIZATION?

• DEFINITION: corporations that are "organized and operate exclusively for charitable, educational, or religious purposes", no substantial part of whose activities are lobbying or trying to influence legislation, and which do not endorse political candidates, and no part of whose income "inures" to the benefit of its members, directors, or others [except as compensation for services actually performed]. Now let's break this down and look at each part of the definition as it relates to a charitable [as opposed to "religious" or "educational"] organizations.
  
  
• ORGANIZATIONAL TEST: the corporation must be "organized" exclusively for charitable purposes. To meet this test specific language must be included in the articles of incorporation stating that [1] the organization is organized and operated exclusively for specified charitable purposes; [2] none of its earnings or assets can be distributed to officers, directors or other private individuals [although payment of reasonable compensation for services is permitted]; and [3] if it dissolves, the organization's assets are to be transferred to another charitable organization (that is, its assets are currently dedicated to charity). Also, its organizational documents cannot authorize it to engage in political activities or substantial "lobbying" activities. If these requirements are met, then the organizational test is satisfied. The proper working for these paragraphs can be found in IRS Publication 557.
  
  
• OPERATIONAL TEST: the organization must "operate" exclusively for charitable purposes. Whether or not you meet this test depends on what you put in the "narrative" portion of IRS Form 1023 (see below). The following are recognized by the IRS as charitable purposes:
  
  * Relief of the poor and the underprivilaged. For example, providing low income housing, developing employment opportunities, etc.
  
  * Lessening the burdens of government, for example providing community social service facilities, supplementing government assistance programs
  
  * Combating community deterioration. For example, commercial area revitalization, housing rehabilitation, increasing or improving housing stock, etc.
  
  * Eliminating prejudice and discrimination. For example, operating home purchase programs related to neighborhood integration, or a minority business assistance program.
  
  It should be recognized, however, that "lessening burdens of government" and "combating community deterioration" are general catch-alls which also cover many nontraditional charitable activities. Therefore, a careful description in the narrative section of your application is needed of the "charitable purposes" to be achieved
  

• The Meaning of "Exclusively".  To be exempt the organization must be "exclusively" charitable (etc.).  You would think it means that an organization can't do anything but conduct charitable activities. However, the IRS and the courts have interpreted "exclusively" to mean "substantially". That is, an organization can carry on "incidental" non charitable activities. For example, a charitable organization can conduct some business activities that are unrelated to its charitable purposes without losing its tax exempt status [see the discussion of "unrelated trade or business" below]. Remember, however, that the IRS will look closely at organizations that operate in a manner that makes charity appear to be only a secondary purpose.

TWO TYPES OF 501(C)(3) ORGANIZATIONS: PUBLIC CHARITY vs PRIVATE FOUNDATION - 

• In granting 501(c)(3) status the IRS will classify the organization as being either a "public charities" or "private foundations".   The choice is made by the IRS and not the organization.

• The distinction has to do with the sources of an organization's support.   For example, The Ford Foundation is a "private foundation" because it does not get any support from the general public or the government and it is not affiliated with or controlled by another organization which itself gets public support.  In contrast, your local United Way is a "public charity" because it receives broad public support and organization that depends on government grants is a "public charity" because government grants are considered a public support.

• ADVANTAGES OF BEING A "PUBLIC CHARITY":

• Private foundations have more restrictions on their activities

• The rules governing the deductibility of contributions are more favorable for public charities.

• For public charities there is no tax on its investment income [if it has any], while a private foundation must pay a 2% tax

• The IRS considers certain organizations to be public charities simply by the nature of their activities (schools, hospitals, religious organizations, etc.) or because the organization is affiliated with or controlled by another public charity.

• For most 501(c)(3) organizations, however, the IRS presumes that it will be a private foundation UNLESS that organization can overcome the presumption by demonstrating that a sufficient amount of its financial support comes from "public sources" [small contributions from the general public, grants from governmental agencies, and grants from other public charities].

• PRIVATE FOUNDATION STATUS: to overcome the presumption an organization must demonstrate that it receives (or expects to receive) at least one third of its support from small contributions from the public or from the government and it does not receive too much income from investments, it can qualify as a public charity under either of the following two similar options: Sections 509(a)(1) or Section 509(a)(2). If the organization does qualify it will not be subject to the restrictions applicable to private foundations. As you are completing the application and you are in doubt as to which option to choose, go with 509(a)(1) or check the box on the application asking the IRS to decide which of the two is best. They will base their decision on budget and balance sheet sheet sections of the application. The IRS is trying to find out where your present financial support comes from and where you expect to get your future support.

• "ADVANCED RULING" ABOLISHED:  On September 9, 2008, the IRS issued regulations, which eliminate the advance ruling process for a section 501(c)(3) organization. Under the new regulations, a new 501(c)(3) organization will be classified as a publicly supported charity, and not a private foundation, if it can show that it reasonably can be expected to be publicly supported when it applies for tax-exempt status.

• Under the old regulations, an organization that wanted to be recognized by the IRS as a publicly supported charity instead of a private foundation had to go through an extended two-step process. First, the organization had to declare that it expected to be publicly supported on an on-going basis. Then, after five years, it had to file Form 8734, Support Schedule for Advance Ruling Period, showing the IRS that it actually met the public support test. If it didn't meet the test, it was designated a tax-exempt private foundation and would be subject to stricter rules

• The new rules no longer require the organization to file Form 8734 after completing its first five tax years. Moreover, the organization retains its public charity status for its first five years regardless of the public support actually received during that time. Instead, beginning with the organization's sixth taxable year, it must establish that it meets the public support test by showing that it is publicly supported on its Schedule A to Form 990.

RESTRICTIONS ON 501(C)(3) ORGANIZATIONS:

• LOBBYING: the basic rule is that a 501 organization cannot attempt to influence legislation either directly or indirectly. This includes local legislation pending before a city or county commission. An "insubstantial" or incidental amount of lobbying is permitted if an organization is a public charity [see definition below]. These terms are difficult to quantify. Five percent is sometimes use used as an informal guideline, i.e., an organization's staff should not devote more than 5% of its time and or 5% of the organization's annual budget for lobbying. But this is not an official IRS guideline. However, a public charity can make lobbying expenditures up to certain specified levels if it files a special "election" under Section 501 of the Internal Revenue Code using IRS Form. Even if the organization exceeds the specified expenditure levels, the worst that can happen is that it will have to pay a tax of 25% of its excessive lobbying expenditures. It doesn't lose its exemption unless it keeps exceeding the limits in subsequent years.

• CERTAIN ACTIVITIES ARE NOT TREATED AS "LOBBYING". These include [1] talking to legislators about legislation that might affect an organization's tax exempt status or existence, but this does not include budgetary or funding matters: [2] activities related to non legislative decisions, such as opposing or supporting the issuance of regulations; [3] making available the results of nonpartisan studies; and [4] responding to requests to testify before legislative committees [your organization must be invited in writing by the chairman of the committee].

• NO ENDORSING POLITICAL CANDIDATES: Section 501(c)(3) organizations cannot support or oppose political candidates. No partisan political campaign activities, however minimal, are allowed. Section 501(c)(3) groups can distribute nonpartisan "voter education" information, but such information should be carefully reviewed to make sure that it is a fair presentation of information about all candidates and is not "slanted". It cannot be anything that can be construed as an attempt to persuade the public one way or the other. Also, Section 501(c)(3) organizations are not permitted to allow groups or individuals to use their facilities and equipment to campaign for candidates.

• NO "PRIVATE INUREMENT": You have to be very careful about making payments to "insiders" (such as directors, officers, etc.).  The IRS will take away your tax exempt status if feels that the primary purpose is to  benefit insiders rather that the exclusive furtherance of charitable purposes.  This is called "private inurement".  It can take many forms. Examples include unreasonably high salary payments and certain types of business dealings between the corporation and its directors and officers.  This is a MAJOR concern of the IRS and many of the questions on the application (Form 1023) have to do with potential private inurement.

COMPLETING THE APPLICATION (FORM 1023)

• STEP 1: Form 1023 has excellent instructions (a separate document from the form itself). Follow the instructions given to you by the IRS: this outline will not contain a step by step guide for completing the paperwork. Read the instructions to Form 1023 carefully. Also, read IRS publication 557.

• STEP 2 - Employer ID Number: One of the first questions on the application is your "Employer Identification Number" (EIN)  If you don't have one you will need to get it from the IRS.  Download Form SS4 from the IRS website and follow the instructions.  Note: the instructions on Form SS4 tell you how to get your EIN number over the telephone from the IRS if you are in a hurry.  If you do this, however, It is probably a good idea to first fill out Form SS4 prior to calling (that way you will have done the research before the IRS person starts peppering you with questions of a technical nature)

• STEP 3 - Prepare the "Narrative":  Part IV of Form 1023 asks you to describe in detail your organization's past, present, and future activities.

• This one question [along with the contents of your articles of incorporation] will determine whether or not your organization qualifies for exemption

• The rest of the application is merely to determine if there is any improper "private inurement" (etc) and to determine what type of 501(c)(3) organization you will be (a "public charity" for a "private foundation").
  

• Here are some pointers for your "Narrative"

• DISCLOSURE: disclose all proposed or existing activities. Failure to disclose is a crime if your organization plans to implement an activity that you know is an "unrelated trade or business", consider "spinning it off" into a separate for profit subsidiary so that you will not have to include it in your narrative discussion. In such a case the activity would be carried out by a separate corporation [your subsidiary] and would not be an activity of the applicant corporation. If a particular activity is on the borderline and you do not want to create a subsidiary, give it your best shot. You must fully disclose the activity. You can put it in the best light and you can give the IRS your best argument for why it should be considered to be "related" to your charitable purposes.

• PROVIDE DETAILS: Described in detail your proposed or existing programs. Fully describe the identity of your proposed customers for clients. Describe eligibility. Describe the physical facility(ies) that you will use (e.g. location, size, layout, rent, etc.). Describe your proposed or existing staff. Described in detail how you will fund your operations. In short, before applying, you will need to devise a detailed business plan. If you apply without giving sufficient details, the IRS will hold up your application until you answer their numerous written questions that they will submit to you for purposes of getting the detailed information that they will require. Remember, the IRS does not like to give out exemptions. 

• For each activity provide the following details

• FOCUS ON EXEMPT PURPOSES: focus your narrative around achieving your organizations exempt purposes. If your activities are to be located in a low income neighborhood, start off your narrative by using a detailed description of that neighborhood. Include statistics on the poverty rate, housing conditions, percentage of underwent mothers, unemployment rates, ethnic breakdown, etc.. In order to establish how "bad" things are, compare the neighborhood's statistics to similar statistics for the county or city as a whole. You can get this data from the City and County Data Book of the U.S. Census Bureau. Often, the county or city government can give you copies of studies that they have previously prepared. When describing the activity, stress over and over how the activity will alleviate poverty and how the beneficiaries of your services will be low income persons, etc.

• AVOID "BOOBY TRAPS": don't brag about how you plan to go down to City Hall and demand better code enforcement in order to clean up the neighborhood (etc.). This could easily be interpreted by the IRS to the lobbying. If lobbying will be a major activity for your cooperation you may not qualify for 501(c)(3) status. Also, don't write about the benefits that your "members" will enjoy. The activities of charitable organizations must benefit the entire community and not just their own members. If only the "membership" were to benefit, the IRS would interpret the activity as "private inurement" and would automatically disqualify the corporation. Your members are allowed to benefit but only as part of the larger community but not as a privilege inherent in their "membership". If the whole purpose of your organization is to bring financial benefit to your membership, your organization probably will not qualify for 501(c)(3) exempt status.

• BE CAREFUL ABOUT "UNRELATED TRADE OR BUSINESS":  In describing your activities in the narrative be aware that 501(c)(3) organizations can not have a "substantial" amount of "unrelated business activity".  Each of your proposed activities must "relate" to your charitable purpose.  In other words, each activity must contribute importantly to the achievement of your organization's charitable objectives as specified in your organization's articles of incorporation. It is essentially a "purpose" test. For each activity described in your narrative you must explain why the organization doing it.  Is it doing this to make money or is it doing this to achieve a charitable goal? To establish that a business activity is a related business you must be able to show that it is merely an instrument to achieve a charitable purposes and that the activity is not an end in itself.  In other words, you must show that the the purpose is not merely to make money (even if that money is to be spent on charitable purposes the activity itself must further a charitable).  The bottom line is the issue of unfair competition. You have to convince the IRS that the proposed activity is going to be different from similar activities conducted by non exempt corporations. For example, perhaps the activity will provide employment to members of the charitable class. But many non exempt businesses also provide employment opportunities. You must distinguish what you are proposing to do. Perhaps your proposed activity can be considered "related" if the focus is on helping the employees through providing supportive social services, training, and other assistance that an ordinary employer normally would not furnish so that it is clear that the business is not being operated to achieve profits but for other objectives. The business operation must have factors that make it different from similar commercial businesses.

FINAL CHECKLIST: send the following completed and signed documents to the IRS at the address indicated in form

• COVER LETTER: prepare a short cover letter to be signed by the corporations president explaining that you are applying for tax exempt status and that your application is attached. Include the following statement: "the attached bylaws are a true and correct copy of the bylaws that are currently in effect".
  
  
• FORM 1023: Your corporation's president should sign on the bottom of the first page. Attach your articles of incorporation (including a "certificate of incorporation" sent to you by your state's corporation department) and the bylaws.
  
  
• FORM 8718: Complete the form and sign it. Attach a check for the application fee that is indicated on the form. Make the check payable to the "Internal Revenue Service".
  

POST APPLICATION

The initial response letter: after submitting the application you can expect a letter from the IRS in about eight weeks. The letter will acknowledge the receipt of your application. Almost always the letter will ask you for additional information. If there are only ten or fewer questions, you are probably in very good shape and you can expect your application to eventually be approved without too much additional hassle. If, on the other hand, there are 15 or more questions, there may be problems with your application. Regardless, answer all questions truthfully and in detail and submit the answers to the IRS within the time deadlines imposed on you in the letter. The letter will give you the name and telephone number of your contact person at the IRS. This is the person who has actually reviewed your file and who wrote the letter (although the letter was probably signed by the district director). It is almost always a good idea to call this contact person and find out exactly what they want to know. Often these contact people can be very helpful and the information that they give to you can help you focus your response to the letter.

Determination letter: eventually the IRS will either send you a favorable or an unfavorable determination letter. If it is unfavorable, good luck and you have our condolences. If it is favorable, congratulations! Save this letter. It is very important. Not only does it give you critical information about compliance and staying out of trouble with the IRS, but your potential funding sources will almost always ask you for a copy of it.


SOME IRS PUBLICATIONS THAT WILL BE HELPFUL:
Click Here to go the IRS download page

• IRS Publication 526 - Charitable Contributions:Organizations that qualify for status as a charity are described. The publication provides rules for determining the fair market value of donated property and explains limits on the size of a deduction based on 20, 30, or 50% of an individual's adjusted gross income.
  
  
• IRS Publication 557 - Tax-Exempt Status for Your Organization: Organizations are guided through the application procedures for obtaining tax-exempt status. Generally, these organizations must complete either Form 1023 or Form 1024 and await a ruling or determination letter from the IRS. If an exemption is granted, it may be effective as of the date of an organization's formation. In some cases, an organization may be issued an advance ruling or determination letter prior to commencing operations. Return and disclosure statements required of exempt organizations are explained.
  
  
• IRS Publication 598 - Tax on Unrelated Business Income of Exempt Organization:
  
  
• IRS Publication 1391 - Deductibility of Payments Made to Charities Conducting Fund-Raising Events:Helps sponsors of fund-raising events carefully word the extent of a donor's eligibility for a charitable contributions deduction.
  
  
• IRS Publication 1771 - Charitable Contributions--Substantiation and Disclosure Requirements:The Revenue Reconciliation Act of 1993's substantiation and disclosure requirements for donors and charities on contributions made after December 31, 1993 are reported. It is recommended that charities familiarize themselves with the new law in order to avoid failure to meet disclosure provisions that might be subject them to penalties.